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The Pitfalls of ETFs

Here's the good news about the bad news about ETFs: You are your own worst enemy. Aside from the obvious risk of the securities in your ETF dropping in value (which is beyond our scope of superpowers to stop), the remaining concerns can be washed away with a little discretion and trading temperance on your part.

It doesn't take much to avoid the tripwires, which basically amount to buying an ETF without understanding what it's based on and not watching your brokerage costs. Let's dish a little more detail.

Double coverage

If you're already getting shrimp cocktail for an appetizer, you're not going to order shrimp casserole as an entrée. Well, you might, if you were really in the mood, but halfway through the meal even the biggest seafood fan would probably cry, "Overkill!" The same thinking applies to ETFs, and mutual funds for that matter. If you're already holding a lot of technology stocks, for instance, a tech-oriented fund is probably a bit much for your portfolio's palette.

In addition to sector overkill, watch out for ETF morphing. An ETF based on a general-criteria index (like a growth index) is more apt to wander in its composition than one based on a sector-specific index (like biotech). Hypothetically, a nanotech boom might swell the ranks of growth indices with nanotech stocks. Sure, nanotech may be the place to be for growth investors and the additional exposure warranted. However, an inattentive (and potentially anti-nanotech) investor might not be aware of the large sector bet that just crept into his or her growth portfolio.

Non-ETF ETFs

The pro-ETF argument, as well as the pro-indexing argument, is predicated upon the automated nature of the investment. The logic goes that the absence of both fallible human judgment (apologies to the humans out there) and human salary requirements make indexing a performance- and cost-smart investment.

With all the buzz about low fees and index-tracking portfolios, you'd think that the term "ETF" would never pertain to anything involving active (read: human) management. Not quite. Beware of closed end mutual funds gallivanting as ETFs. Some purveyors of actively managed closed-end mutual funds -- that is, mutual funds that trade during the day like stocks -- have decided that because they offer funds that are exchange-traded, they not only have "exchange-traded funds," but also "Exchange-Traded Funds." Hence, they claim, by virtue of abbreviation they have "ETFs."

We won't get wrapped up in the semantics. But if "ETF" means the same to you as it does to most of the investment community (including the SEC), you should stick to referring to this would-be ETF crowd by its long-standing title: closed end mutual funds. Although many of these human-run wannabes have low fees and probably aren't bad investments, a key difference is that mutual funds only disclose their positions quarterly, whereas ETFs (at least the "real" ETFs that share a set of exemptions from the Investment Company Act of 1940) disclose their positions every 15 seconds via Specialists (exchange professionals who match up buyers and sellers).

Since large investors can buy ETFs and subsequently swap them for their underlying shares, this frequent disclosure keeps ETFs' prices closely tied to those of their underlying indices, adding a sort of additional stability not found in mutual funds. Furthermore, many closed-end mutual funds use leverage, which creates the potential for diminished (as well as enhanced, to be fair) returns and price volatility

But wait! There's more. If you'd like more complexity, you won't have to wait long. Also a possibility are actively managed funds that would be "real" ETFs. Such funds would track securities bought and sold by a human manager, but would still likely have some sort of disclosure requirement. But disclosure is a sticky affair: Portfolio managers, seeking to capitalize on the exclusivity of their research, want less of it; those concerned with shareholder rights and safety prefer more, partly to make sure that an ETF's share value doesn't diverge from those of the index it's supposed to track.

However, the same transparency that allows large investors to keep an ETF's price tied to its underlying securities would give skinflints a chance to piggyback off a manager's research by simply choosing to hold the same securities as the fund (although they'd pay a lot in transaction fees if they did this frequently). By matching up changes in recently disclosed positions with outstanding sell or buy orders, unsportsmanlike investors could jump in front of trades before they're fully executed. (For example, if a fund was in the beginning stages of dumping a large position, he or she could quickly short sell the stock with the assumption that the fund's heavy selling would likely drive down the price.)

In other words, since large orders can take time to fully execute, a spate of "nimble" little sell orders could theoretically "use up" the highest-paying demand for a stock. So a fund that starts selling at a moderately high price ends up unloading the bulk of its shares at a disappointingly low price. In trading parlance, its orders would have gotten "gamed."

So what's an investor to do? Actually, things aren't as bad as they look. For now, note that except for HOLDRs (which, though passively managed, are technically not index ETFs but are similar enough to be lumped with them), anything claiming to be an ETF without mentioning an underlying index deserves close scrutiny -- especially anything prefaced by the words "closed-end."

Fortunately, it only takes a quick look at an ETF's description (descriptions are available on the issuers' websites) to see what it's all about. Although this may sound like overkill, it's easy to do and, we think, a necessary step for all investors. The most important thing is to simply be aware of what you're buying (which can do wonders for other areas of your portfolio, too). That way you won't be caught holding a non-ETF ETF. Unless you want to, of course.

No investor wants to wake up with a stranger in his or her portfolio. But once you know exactly what you're buying, there's one more tripwire to avoid...

Trading costs

Sometimes it's the little things that count the most. In the case of ETF investing, it's brokerage commissions. Finding the perfect ETF for your portfolio and then paying an arm and a leg to a broker to buy shares is like being disqualified at the Olympic trials for a false start. (Thankfully, your brokerage bumble won't be broadcast to the entire world.)

Don't be distracted by the fact that their internal fees are lower than most mutual funds'. You still have to pay to trade them. While ETFs don't cost any more to buy and sell than regular stocks, frequent trading involving small amounts hurts. (The precise definition of "small" depends on your trading costs and holding periods, but some folks use $1,000 as a threshold.)

As an example, pretend you invest an initial $5,000, followed by monthly additions of $500, in both a mutual fund (charging a 1.6% management fee but no trading costs) and an ETF (with a .4% management fee and $15 per-transaction trading costs to your discount brokerage). For simplicity, we'll assume 10% returns for both funds and ignore the fact that the mutual fund will likely be less tax-efficient (although by an unknown amount). We're just isolating the transaction fees in this example. Because of those transaction fees, it would take 3.25 years before the ETF's lower internal fees put its overall account balance ahead of the mutual fund's. Switch to $250 monthly additions, and it takes almost six years. $100? More than 11.5 years. (Note that the higher the returns, the faster ETFs will overtake mutual funds.)

Because of transaction costs, ETFs don't work well for dollar-cost averaging and, also don't tend to be available through 401(k) plans. However, you can avert some of the fee bleed by using an ultra low-cost discount broker (though you will sacrifice some in service). If you're looking for a low-cost brokerage account, here are some shopping guidelines.

What to remember

Parting thoughts? In principle, ETFs aren't any more complicated than their underlying securities. If you know enough to buy those, then you know enough to buy ETFs. A little due diligence (finding out what's in that ETF) and some trading restraint (watch the brokerage costs) and you'll avoid the most common foibles. There's really nothing more to it than that.